The Bull Bear Trader discusses market events and news with an interest in understanding risk and return in both bull and bear markets. Discussion topics include trading and hedging strategies, derivatives, risk management, hedge funds, quantitative finance, the energy and commodity markets, and private equity, as well as an occasional investment opinion.

Even while equities were rallying over the last few months, some well-known hedge funds were increasing their exposure to gold (see WSJ article). Some of those buying gold, gold futures, and shares of gold producing companies include Greenlight Capital, Paulson and Company, Eton Park Capital Management, and Blue Ridge Capital Holdings, among others. Yet, instead of providing a hedge against a market correction, the move appears to be motivated more by a worry of excess spending and borrowing by the government, resulting in an eventual spike in inflation, and rally in gold prices. While the recent market run has scared some away from the trade, many others are staying long, and even adding to positions, with current gold-related hedge fund investments coming in on average around 5 percent of assets. With gold still holding above $900 an ounce, there is some worry that a crowded trade will keep the shiny metal from moving much higher in the short-term. Nonetheless, for those with a longer investment horizon, there is still an expectation that the excessive printing of money will eventually cause the chickens to come home to roost, validating those who continue to stay long gold.

The market rally off its recent lows is paying off for some contrarian investors (see WSJarticle). While contrarian investing can mean many things, it often involves buying out-of-favor and beaten-down stocks, or selling those that are over-extended after a nice, and often too-far, too-fast, rally. Essentially, contrarian investors often go against the grain of market sentiment. Of course, given the massive sell-off, some could argue that the markets had no were else to go but up, but timing is important, and hindsight is 20-20. Whom among us was 100 percent certain late last year that the markets were not going lower, or for that matter, were going to recover at all anytime soon, even for a quick bear rally? Even successful contrarian investors such as Warren Buffett, Bill Miller, and David Dreman had a difficult 2008, with Buffett himself adding to down investments prematurely. While those with less than perfect timing may eventually be proven to once again beat the market if held long enough (often a requirement for contrarian investors who have low levels of turnover and high levels of patience), those that are most successful understand both timing and value. It is important to remember that beaten down companies can go lower, or even fail, while those running up too fast can keep soring as the markets remain irrational longer than your ability to remain solvent. But now, in the mists of a nice bear (or new bull) rally, it is easy to once again have stars in our investing eyes. Yet while we dream, contrarian investors may already be looking for those stars that are ready to fall back to earth after a nice, and possibly unjustified, run. After all, summer is often a good time for spotting shooting stars, which are really not stars at all, but bits of dust and rock burning up as they fall from the sky. Maybe now is the time to start enjoying the show.

As the current administration continues to scold hedge fund "speculators" and blame them for potentially forcing Chrysler into bankruptcy for not accepting a deep discount on their debt (before they finally relented), those same firms may now hold more keys to the success of some of the programs being pushed by the same folks doing the scolding (see Bloomberg article). While smaller in numbers and size than just one year ago, hedge funds are still in many instances those with the most capital and risk tolerance to participate in programs such as the TALF and PPIP. Yet, while hedge funds like making money, they hate losing it even more, especially when those losses are driven in part by the rules of the game being changed. Given the recent move to ignore and subordinate more senior debt to a status lower than other parties, hedge funds may be more cautious with future investments opportunities.

Such program participation may soon get another test as hedge funds weight their options as GM goes through its own restructuring. Holders of GM bonds have just a few weeks to decide if they want to swap their debt for a 10 percent equity stake in the company - while the government and the United Auto Workers union-run health care funds get 50 and 39 percent, respectively. While not only getting the short end of the stick, those debt holders who also hold CDS contracts would most likely favor a bankruptcy filing (see Financial Times article). Estimates have investors holding $34 billion in CDS on GM, with profits on the order of $2.4 billion if GM were to default. In what is not much of a surprise, current CDS prices are indicating that a bankruptcy filing is likely. The complicated and extensive lines of debt and derivatives will make both a GM bankruptcy, and any strong arm tactics, much more difficult to execute. Given less of an incentive to participate in the next restructuring, hedge funds may find others offering a little more cooperation, and maybe even a seat at the table going forward. At some point, you cannot keep slapping the hand that may save you.